October 05, 2008

Weekly Standard: What is Wall Street these days, anyway?

Before the last of Wall Street gets sold off as day-old fish on Fulton Street or washed into the East River altogether it’s worth asking, what is Wall Street these days anyway?

Thanks to Dick Grasso and CNBC, most of us think of Wall Street as balding men in ugly solid-colored suits yelling at each other and throwing litter on the floor of the New York Stock Exchange. Not even close. They might as well be holograms from Disneyland’s Haunted Mansion, just a hangover of years gone by. Or maybe Wall Street is stockbrokers, calling you at dinnertime, trying to put you into a few shares of some hot IPO. Or sleek bankers, guys (mostly) in gray Armani suits, blue shirts with white collars, and Hermès ties, jetting off to London to close some important deal. Not anymore.

Thanks to Dick Grasso, most of us think of Wall Street as balding men in ugly solid-colored suits yelling at each other and throwing litter on the floor of the New York Stock Exchange. Not even close.

So what is it? From 40,000 feet, Wall Street is about access to capital. The stock market trades every weekday, and sometimes slowly, sometimes violently, picks the economy’s winners and losers. Actually, it’s not the market, it’s you and me, our mutual funds and pension plans, the collective “we,” that do the picking via our buying and selling. It’s nice to be needed. You may not even realize it, but magically, the value of companies with great prospects goes up, meaning they can raise capital much more cheaply to hire smart programmers or build another solar panel factory. The flip side is that the price of companies doing all the wrong things (think General Motors and now Lehman Brothers) goes down, starving them of capital, a punishment for screwing up, until they disappear or do something to turn themselves around. The stock market, which is really you and me, does the dirty work of hiring and firing managers and green-lighting or killing projects. Pretty cool.

On the street level, of course, Wall Street is a lot nastier. After 20 years in the business, when I think of Wall Street, I think of alpha dogs generating revenue however they can: getting deals done, fighting for market share against all the other firms, and then at the end of the year, on the inside of their firms, unsheathing the political knives to carve up the ever growing bonus pool, and maybe also carve up each other. Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.

Back in the days of private partnerships, White Weld or Brown Brothers or even Morgan Stanley, that was fine. They traded stocks and made good money. They offered advice on mergers and acquisitions and got paid handsomely. But in August 1983, the stock market and the U.S. economy took off. So did mutual funds. And Silicon Valley. And biotech. And a massive service economy. More capital was needed to fund the growth of great companies Think of all the technology companies that didn’t even exist in 1983. Wall Street partners had to pay for memberships in Greenwich country clubs, so partnerships couldn’t retain much earnings. They needed to tap those same public markets, and so went public to raise huge buckets of capital to help their clients. What a great 25-year run!

A very subtle change ruined the party. The same PC and Internet technology that was sweeping corporate America and getting rid of tellers and travel agents and secretaries and typesetters was also invading Wall Street. No one needed a broker anymore—you could do it all online. Traders at firms were being replaced by electronic trading systems that were faster, cheaper, and don’t show up late for work after taking clients out to Smith & Wollensky’s.

By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with,
were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.

Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.

Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

It was the easy trade. Borrow at 3 percent and make 6 percent or 8 percent or 10 percent. They liked it so much, they levered up. Meaning instead of just borrowing a dollar for every two dollars of assets they owned (which by the way, thanks to the 50-percent margin requirement, is the amount of leverage that you and I are allowed to buy stocks from these same firms), they borrowed 20 to 1, 30 to 1, and even 50 to 1, if they could get away with it. And man, it was a lucrative trade. So why not?

I’ll tell you why not. Because all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets fl ashed green. Risk was a four-letter word best not said in polite company. Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Bear Stearns gone. WaMu too, into the belly of J.P. Morgan. Wachovia into Wells Fargo (or is it Citi?). Fannie and Freddie are the new U.S. Department of Mortgages and are closing their K Street offices. Lehman is dust in the wind. AIG in the penalty box. Merrill Lynch is a subsidiary of Bank of America, which barely survived their purchase of Countrywide Mortgages and, the word is, they won’t change their name to Lynch America Countrywide. They should.

And horror of horrors, Goldman Sachs and Morgan Stanley are now bank holding companies. Yeah sure, free toaster jokes are flying, but the net effect is they will now be restricted to 10: or 12:1 leverage, instead of 30.

There is plenty of finger pointing to go around. You can blame the Fed for low interest rates, rating agencies for putting AAA ratings on garbage loans, the SEC, short sellers, monoline debt insurers, lying borrowers, mark to market accounting—heck, let’s blame the Chinese for lending us our own dollars.

When running money, I bought plenty of stocks only to see the company screw up and the stock drop. I could try to blame the company, but my investors would blame me. And rightly so. It was nobody’s fault but mine. The buck stops at the management of these firms for chasing a bad trade and not sticking to their bread and butter businesses.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on WallStreet in 2007 will be doing something else by January.

And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ’em public, bank ’em, and grow with ’em. It may not be as exciting as the last few years, but it beats getting dumped in the East River. ♦

Comments

Great stuff. I've heard and read a lot of crap about whats happened, and this is the best yet.
In the last week or so I've become a fan of your writing.
Continued success and keep telling it like it is.

I still do not understand why we do not know these people's names. A great wrong has been done to society, and honestly, those responsible ought to be forced to face the crowd. Hearing of severance packages and businesses starting over across the street, does not sit well with main street. It is great to explain what happened and how. The next step is to make sure it does not happen again. The FBI is investigating and if they are able to convict, I hope serious prison time is the sentence. Hard for me to believe all that money was obtained honestly. I think some people need to provide information to help the DOJ convict the worst offenders.

They're selling dark postcards of Wall Street
They're painting passbooks black
The air is filled with busted banker dread
The circus is in town
Here comes the blind SEC commissioner
They've got him in a trance
One hand is tied to the tight-rope walker
The other is in his pants
And the FBI they're restless
They need somewhere to go
As Lady luck and I look out tonight
From Desolation Row

Bailout Cinderella, she seems so easy
"It takes one to know one," she smiles
And puts her hands in her back pockets
Bette Davis style
And in comes Wall Street Romeo, he's moaning
"You Belong to Me I Believe"
And someone says," You're in the wrong place, my friend
You better leave"
And the only sound that's left
After the town car limo goes
Is Bailout Cinderella sweeping up
On Desolation Row

Now the market moon is almost hidden
The economic stars are beginning to hide
The fortunetelling lady
Has even taken all her things inside
All except for Paulson and Bernanke
And the lame hunchback of Pennsylvania Avenue
Everybody is making love
Or else expecting black market rain
And good old Warren, he's dressing
He's getting ready for the show
He's going to the carnival tonight
On Desolation Row

Now Dick Fuld, he's 'neath the window
For him I feel so afraid
On his sixty-second birthday
He is just an old Wall Street maid
To him, market death is quite romantic
He wears a pinstripe vest
His profession's his religion
Sins of greed yet to be confessed
And though his eyes are fixed upon
Noah's great rainbow
He spends his time peeking
Into Desolation Row

That "Maestro" Greenspan, disguised as Robin Hood
With his memories in a trunk
Passed this way an hour ago
With his friend, a seedy Wall Street skunk
He looked so immaculately frightful
As he bummed a cigarette
Then he went off sniffing drainpipes
And reciting the greek alphabet
Now you would not think to look at him
But he was famous long ago
For playing the free market violin
On Desolation Row

Dr. Bernanke, he keeps his world
Inside a Federal tin cup
But all his terminal patients
They're trying to blow it up
Now his nurse, some local loser
She's in charge of the subprime hole
And she also keeps the cards that read
"Have Mercy on their Souls"
They all play on penny whistles
You can hear them blow
If you lean your head out far enough
From Desolation Row

On the Street they've nailed the curtains
They're getting ready for the feast
The Phantom of the Markets
A perfect image of a priest
They're spoon feeding Hank Paulson
To get him to feel more assured
Then they'll kill him with their con men skills
After poisoning him with their wily shills
And the Phantom's shouting to skinny girls
"Get Outa Here If You Don't Know
Paulson's is just being punished for going
To Desolation Row"

Now at midnight the GOP led by McCain
And their subhuman neocon crew
Come out and round up everyone
That knows more than they do
Then they bring them to the factory
Where the heart-attack machine
Is strapped across their shoulders
And then the market kerosene
Is brought down from their grand old castles
By insurance men who go
Check to see that nobody is escaping
To Desolation Row

Praise be Roubini's Neptune
The Titanic sails at dawn
And everybody's shouting
"Which Side Are You On?"
And Elephant and Donkey Men
Fighting in the captain's tower
While calypso singers laugh at them
And fishermen hold flowers
Between the windows of the crashing market sea
Where lovely mermaids flow
And nobody has to think too much
About Desolation Row

Yes, I received the bullish newsletter
(About the time the door knob broke)
When you asked how my net was doing
Was that some kind of joke?
All these people that you mention
Yes, I know them, they're quite lame
I had to rearrange their faces
And give them all another name
Right now I can't read too good
Don't send me no more newsletters no
Not unless you mail them
From Desolation Row

I was dreamin' when I wrote this
Forgive me if it goes astray
But when I woke up this mornin'
Coulda sworn it was Wall Street judgment day
The S&P was purple and the DOW was gray,
there were traders runnin' everywhere
Tryin' to run from the destruction,
U know I didn't even care

CHORUS
say say Dow heads down to zero Wall Street party over,
oops out of time
So tonight I'm gonna party like it's 1929

I was dreamin' when I wrote this
So sue me if I go to fast
But Wall Street is just a party, and parties weren't meant to last
Paper losses is all around us, my mind says prepare to fight
So if I gotta die I'm gonna watch Cramer tonight

CHORUS
say say Dow heads down to zero--Wall Street party over,
oops out of time
So tonight I'm gonna party like it's 1929

intro 2x
Lemme tell ya somethin'
If U didn't come to party,
don't bother knockin' on Paulsons's bailout door
It's burning a hole in his pocket,
and baby he's ready to ask for more
Yeah, everybody's got an unhedged bomb,
we could all die any day
But before I'll let that happen,
I'll dance my investment banking life away

Oh, they say
say subprime securitization party over,
oops out of time
So tonight I'm gonna party like it's 1929
say say DOW heads down to zero party over,
oops out of time
So tonight I'm gonna party like it's 1929

Wall Street may not be the same anymore but it is still going to represent the financial hub of America in whatever shape and form it takes on post crisis. In that respect why not help create that future with a suggestion. Help create a rule and submit a paper at (Call for papers link at xwallstreeters.com)